Comparisons Of Long Call Vs Long Stock

Long stock

To long stock simply means to take an open position in the stock of a certain company by buying it in the open market. The rationale for buying stock is to earn a profit by selling it at a higher price.

Long call

A call an option contract to buy a certain quantity of shares of the underlying security at a certain strike price. The buyer of the call option has the right to exercise the option contract to own the underlying security.

Example of a long stock strategy vs a long call strategy

ABC Corp is currently trading at a price of $50. Trader A decides to buy 100 shares of ABC Corp as he expects ABC to trade at $60 in 15 days.

Trader B however opts to buy an at the money call option to capture the upside of ABC’s stock price. He buys an option with an expiration date that is 3 months out at a price of $500.

In 2 weeks, the prediction that ABC would trade at $60 came true.

Let us compare the cost of initiating the long call position vs the long stock position.

Executed by Strategy Cost
Trader A Long stock $5000
Trader B Long call $500

To have an exposure to 100 shares, Trader A spends :

$50 x 100 = $5000

Trader B however spends only $500 for an exposure to 100 shares.

In comparison, Trader B spent a smaller amount getting the same exposure to 100 shares.

Let us now examine the profit achieved by both traders.

Executed by Strategy Profit
Trader A Long stock ($60 – $50) x 100 = $1000
Trader B Long call ($60 – $50) x 100 = $1000

As you can see from the above table, both strategies yield the same absolute profit.

Let us compare the return on investment or the profit percentage for both strategies.

Executed by Strategy Return on investment/Profit percentage
Trader A Long stock 1000/5000 x 100% = 20%
Trader B Long call 1000/500 x 100% = 200%

As you can see from the table above, with all things being equal, the return on investment was greater than for the long call strategy than the long stock strategy.

Let us examine the scenario where the price of the underlying security, ABC Corp decreases to $40 by the expiration date of the call option.

Executed by Strategy Loss
Trader A Long stock ($50 – $40) x 100 = $1000
Trader B Long call $500

The loss in the long stock position is $1000. However, Trader A could still hold the stock indefinitely. In cases where the stock is undervalued, the trader could still realise a profit by holding the stock for the long term and wait for it to appreciate.

With regards to the long call strategy, the trader loses $500 as the options expire out of the money and becomes worthless. In absolute terms, the trader who executes the long call strategy lost less money  than the trader with the long stock strategy.

Executed by Strategy Percentage loss
Trader A Long stock $1000/$5000 x 100% =

20%

Trader B Long call $500/$500 x 100% =

100%

From the above table, Trader A with the long stock strategy makes a loss of 20% while Trader B with the long call position makes a loss of 100%.

Time value considerations to make when buying call options

Option Premium

Options are essentially wasting assets. As they get closer to expiration date, they suffer from time value decay which causes the overall option premium to decrease if the price of the underlying security stays constant till expiration of the option.

A trader who buys an option intends to sell it at a higher price so that he can profit from it. That being said, in order for the option to trade at a higher price, the price of the underlying security must rise. The magnitude of the price increase will affect the option value by causing it to increase as well.

Since options are wasting assets, the upward price move must happen within the life of the option in order for the option to stand a chance of being traded at a higher price. Case in point, the trader who longs a call must look for a catalyst in the underlying security that will cause its share price to move upwards significantly within the life of the option. If the trader is still bullish but is uncertain of the timeframe by which the stock will make a move, he should choose the long stock strategy instead as he can hold onto the stock indefinitely and collect dividends from it.

 Size of investment

As you can see from the above table, Trader A’s investment is larger than Trader B’s investment. A long call strategy requires less resources for the same exposure the underlying security than a long stock strategy.

Dividends

The holder of the stock(long stock) is entitled to dividends paid by the publicly traded company. The call option holder(long call) is not entitled to dividends paid out by the publicly traded company.

Magnitude of price movements of the underlying security

With large price increases, the long call earns a higher return on investment or a higher percentage profit than the long stock strategy.

With price stagnations till the expiration date of the option, there is no loss on the long stock position but the long call position incurs a 100% loss as it expires worthless.

When the price of the underlying security moves down significantly till the expiration date of the option, there is a loss on the long stock position but the long call position incurs a 100% loss as it expires worthless. In absolute terms, the long call position may experience a smaller loss than that loss incurred by a long stock strategy.

Read: Stock repair strategy

Long Call : Profit From Rise In Price Of Underlying security

Buying options : Long call & put options

Execute A Synthetic long call : Bullish strategy

Synthetic Long Stock : Bullish strategy

Synthetic Long stock with options of different strike prices(split strikes)